Updated: Jun 9, 2022
The buydown is a mortgage financing technique that the buyer uses to reduce the amount of their mortgage by reducing the interest rate for the initial few years of the loan or for the the entire life of the loan. A buydown may also involve purchasing points on closing which acts as an upfront fee that reduces the interest rate. The choice of buying a buydown usually depend on the interest rate you qualify and how long the borrower plans to stay on the home. For example, 2-1 buydown means the borrower will have a less interest rate for the first two years of the life of the loan.
Buydown - Buyers
The buydowns are negotiated between the buyers and lenders and the buyer agrees to pay an upfront fee called mortgage points and in turn get a discounted interest rate for the initial few years as outlined in the policy.
Buydown - Sellers
In some cases, the sellers may offer to provide the buyers with an incentive to make the home affordable for the buyers by lowering the interest rate. The seller usually pays to the escrow and is considered as a seller concession to the buyers. Typically in sellers market the cost paid by the sellers are added on to the purchase price of the home.
Buydown - Builders
Similar to the sellers, some builders may also offer buydowns to help the buyers with the mortgage. This is usually paid as an upfront fee and given as an incentive to the buyers to encourage them to buy their newly built properties.
Mortgage points are also called as prepaid interest points. It allows the borrower to pay an additional amount during the closing to get a lower interest rate. Usually one point equals to 1% of the loan amount and in turn the lender provides a discount rate of 0.25% in interest rate.
For example, if a borrower had a $100,000 loan at 5.25% interest rate, the borrower might pay $1000 (1% of the loan amount) and get a discounted interest rate of 0.25%. So, the new interest rate would be 5%.
Lowering the interest rate not only save money in the monthly mortgage but also saves money on the entire life of the loan.
It works best if the borrower plans to stay on the home long term.
By calculating breakeven point, we can decide if it is worthwhile to buy the buydown. Breakeven point is the amount of time it takes to recover the cost paid on the discount points to lower interest rate. It is calculated by dividing the cost of the discount points to the monthly savings achieved.
For example, if the borrower has a loan amount of $100,000 and interest rate of 5%. Borrower purchases 4 discount points to lower the interest rate by 1%. His new interest rate would be 4% after paying the $4000 (4 points) in discount rate. The monthly mortgage amount would drop from $416 to $333. The difference is $83. The breakeven point is calculated by dividing $4000 by $83. So, it takes 48 months to recoup the amount of money paid for the buydown. If the borrower plans to keep the home long term, then buydown may be a good option.
2-1 buydown provides the borrower with a discounted rate for the first two years. In this option, the borrower gets 2% discount rate for the first year and 1% discount rate for the second year.
For example, if the borrower buys a home worth $500,000 with a standard interest rate of 4% for a 30 year term loan, then the borrower will have a 2% interest rate the first year of the term, 3% interest rate for the second year of the term and 4% standard interest rate from the term year 3-30.
3-2-1 buydown provides the borrower with a discounted rate for the first three years. In this option, the borrower gets 3% discount rate for the first year, 2% discount rate for the second year, 1% discount rate for the third year.
For example, if the borrower buys a home worth $500,000 with a standard interest rate of 4% for a 30 year term loan, then the borrower will have a 1% interest rate the first year of the term, 2% interest rate for the second year of the term, 3% interest rate for the third year and 4% standard interest rate from the term year 3-30.
Pros of a Buydown mortgage
Buydown helps the buyers to afford home and mortgage with less interest rate in initial years.
This is best suited for the buyers who expect their income to rise over the years.
Cons of a Buydown mortgage
The mortgage payments may be substantially higher once the initial discounted period ends.
Buydown option may not be available to some types of properties or some types of mortgage.
If the income is not expected to increase overtime, it might be a struggle to make the higher mortgage payments after the initial discounted period.
Temporary and permanent Buydown
Mortgage buydown may be set up in different ways and they vary upon the lenders.
2-1 buydown and 3-2-1 buydown are usually classified under temporary buydowns as the interest rate is low only for the initial few years. This temporary discounted period are called as Temporary buydown.
Paying mortgage points to get a discounted interest rate reduces the interest rate over the life of the loan. These are called as permanent buydown.
In permanent buydown, 1 point is calculated as 1% of the loan amount and lowers 0.25% of the interest rate.